Coronavirus: Recession or depression — lets be prepared

Given the RBI guidance, here are some key considerations for banks across three potential scenarios on how the spread of COVID-19 and its impact can pan out in the future.

is a mild and optimistic scenario which assumes that coronavirus may be contained by governments’ efforts. Also, a medical solution/vaccine may be developed which can eliminate the threat to public health. In this case, there is no reason to expect a significant long-term investment effect. However, a lockdown will result in a temporary slowdown in growth and earning of the corporates. The impact is to be restricted to the next 3-6 months.

Scenario 2 is a moderate scenario which assumes no immediate breakthrough with a vaccine/medicine. However, it considers that people will develop immunity over the period. COVID-19 will become endemic like regular cold and cough. Medical advances would reduce the frequency and severity of the infection. However, the economy would fall into recession (economic activities decline for two consecutive quarters).

Scenario 3 is a severe scenario which assumes that COVID-19 will prolong for an extended period with no sign of containment and cure. The infection and mortality rate would continue to increase which makes an irreversible disruption to global supply chains. Coupled with current oil price war and exhausted central/government measures, the global economy falls into depression. The time horizon of the scenario to be considered is three years or more.

Keeping these scenarios in mind, the banks may consider designing shocks for each of the risk factors and assess the impact on their balance sheets, asset quality, and liquidity. The severity of shocks will increase as we move from scenario 1 to scenario 3.

In scenario 1, we expect defaults to be more pronounced in small and medium enterprises (SMEs), low-rated corporate customers and retail customers with low CIBIL scores. However, scenario 2 and scenario 3 will have an impact across rating classes.

In both scenarios 2 and 3, due to the overall increase in credit risk, we also expect higher risk-weighted assets (RWA) resulting in fall of capital adequacy. In some cases, it may fall even below the minimum regulator prescribed capital adequacy requirement. It would be extremely challenging to raise capital in the current market environment.

All scenarios should capture operational risks like cyber risk, internet shutdown and keyman risk. Due to lockdown, work from home (WFH) had to be extended to even to sensitive operations (like trading activities). Enhanced cyber risks stem from insecure Wi-Fi connections, open printer ports and documents shared on cloud databases. Further, concurrent usage of WFH at this scale along with other residential usage, internet pipes are probably reaching the limits.

In all the scenarios, banks are susceptible to liquidity risk due to multiple factors like a run on deposits, inability to raise funding, disruptions in loan repayment.

In scenario 1, the banks may consider that RBI will ease out liquidity by slashing cash reserve ratio (CRR), Statutory Liquidity ratio (SLR), repo rate, and buybacks. In scenario 2 and scenario 3, these measures will start getting limited or exhausted their effects due to longer time horizon.

The banks can consider the impact on their trading portfolio from a further drop in equities and an increase in volatility. Further, mark to market losses from an increase in corporate credit spread should also be captured. In all the scenarios, the banks should factor in volatile and depreciating INR.

To conclude, there is a lot of uncertainty around COVID-19 and it is very important that banks are prepared for all possible scenarios. This will help in planning and ensuring they maintain adequate capital and liquidity in advance.